Sunday, April 22, 2012

Commodities don't provide "diversification" in a crisis

Investopedia is a great reference tool, particularly for those new to finance. But once in a while it provides advice that may not be entirely accurate. In an article entitled
"Commodities: The Portfolio Hedge" Investopedia tells you why commodities help "diversify" your portfolio.

Investopedia: Commodities tend to bear a low to negative correlation to traditional asset classes like stocks and bonds....

Source: Investopedia

Yes it is true that the average correlation between equities and commodities from 1970 to 2003 has been negative. But if we've learned anything from the financial crisis, it is that correlations are not static and tend to spike in a deleveraging environment (whether you are dealing with mortgages, equities, corporate bonds, etc.). The chart below shows the correlation between the CRB Commodity Index (or equivalent basket of commodities) and US equities going back to1915 - almost a century of historical data.

In a crisis a commodity basket may not be very effective in providing the diversification one would expect from historical correlations (reaching 80% in the recent crisis as commodities sold off with equities). The same thing happened in 1929. There is nothing wrong with having commodities in a portfolio of assets. One simply needs to be aware of the reasons the asset class is part of it. And the key motive to be long a broad basket of commodities is to protect against inflation, not to try "diversifying" the portfolio.

Update: Good comment from Kostas Kalevras:

There's basically a whole story about how Gorton et al 2004, induced institutional investors such as pension funds to invest in commodities futures as a hedge againt other asset classes. This investment was made through index funds and creates a perpetual long position on the underlying commodity futures. The liquidity injection was so large (of the order of $300bn by 2008) that it pushed oil and commodity futures to a contango situation playing a role in price increases as well as price volatility (due to the funds leaving partially after Lehman).

The process has been documented by various commentators, including the Fed: